29 September 2018

Pakistan Trudges Along a Familiar Economic Path

Elevated energy prices and the lack of internationally competitive exports will continue to drive Pakistan's high import bill and trade deficit.

Spending cuts targeting development will narrow the budget deficit but at the cost of slowing growth and increasing unemployment.

New Prime Minister Imran Khan's great challenge will be to balance his impassioned populism with a pragmatism required to govern Pakistan.

As Prime Minister Imran Khan tries to set a new direction for Pakistani politics, his administration is urgently seeking to resolve the country's most serious macroeconomic challenge: boosting its dwindling foreign exchange reserves. As of Sept. 7, the State Bank of Pakistan's net reserves remained beneath $10 billion. That's less than the three-month import cover recommended by the International Monetary Fund (IMF), fueling speculation that Khan will turn to the U.S.-based organization for a bailout. Indeed, Finance Minister Asad Umar has unveiled a series of measures targeting the widening budget deficit ahead of an IMF delegation visit to Islamabad on Sept. 27. These measures include cutting more than $2 billion in planned development spending, doubling the tax rate on the highest income earners to 30 percent and hiking tariffs on 5,000 nonessential imports.

While reducing its budget deficit is an important step for Pakistan to take, the deeper causes of the country's foreign exchange crisis are linked to its trade deficit. And because energy comprises Pakistan's most expensive import, the combination of higher oil prices and the lack of an internationally competitive value-added export industry will continue to drive the trade imbalance. As a result, Pakistan will continue to rely on external funding to plug its foreign exchange requirements. And Khan's spending cuts mean the price for narrowing the budget deficit will be slowing growth, suggesting unemployment will rise over the next year.

The Big Picture

Pakistan's $300 billion economy expanded at its fastest pace in over a decade during the country's last fiscal year. However, a widening trade deficit is bringing Pakistan back to the brink of a foreign exchange crisis unless it receives a bailout. For Prime Minister Imran Khan, fixing the economy's fundamentals will be his most important task in the early months of his tenure.

Taming the Deficit

Pakistan has a trade problem. The outgoing Pakistan Muslim League-Nawaz administration racked up a $37 billion trade deficit during the 2017-18 fiscal year that ended June 30, the highest in Pakistani history. Energy, metal and machinery imports accounted for the lion's share of the growing import bill. The rising price of crude inflated the cost of energy, already Pakistan's largest import item in terms of value, by nearly 32 percent during the first nine months of the 2017-18 fiscal year, as compared with the previous period. Making matters worse was the central bank-induced depreciation of the rupee — Pakistan's currency has fallen by 15 percent against the dollar since December — which, in turn, made dollar-denominated imports like oil more expensive, even as it has boosted exports.

Meanwhile, the growing expenditure on machinery imports is linked to the China-Pakistan Economic Corridor (CPEC). The $62 billion network of roads, railways, pipelines and special economic zones represents the pinnacle of Islamabad and Beijing's robust partnership. But while CPEC is meant to be a panacea for Pakistan's energy shortages and is expected to spark an economic boom in the long run (though this outcome is far from guaranteed), it requires absorbing steep short-term costs. Finally, payments for iron and steel imports rose 51 percent during the fiscal year's first nine months as demand for construction in Pakistan remains strong.
Rectifying the Imbalance

Pakistan's growing hunger for imports is a function of its strong economic growth. Pakistan's $300 billion economy expanded by 5.8 percent through fiscal year 2017-18. This growth rate is Pakistan's highest in 13 years and was driven by strong expansion across the country's agricultural, industrial and services sectors as inflation remained low. Yet expansion has led to greater import demand, ballooning the trade deficit. While exports have grown, too — thanks to surplus production of rice, cotton, sugar and wheat (and facilitated by a weaker rupee) — they have failed to keep up with import growth. Unless Pakistan develops an internationally competitive export industry by diversifying beyond rice, leather and cotton manufactures — which comprise 70 percent of the country's exports — it will struggle to bridge the gap.

Stagnant export growth also points to a deeper problem. The services sector dominates Pakistan's economy, accounting for 60 percent of output, while the manufacturing and agricultural sectors account for 19 and 21 percent, respectively. The need to advance industrialization in support of a robust value-added, labor-intensive export industry has been a key priority of every government in Islamabad, but until Pakistan resolves its transition from farms to factories, agriculture will continue to absorb a high percentage of the labor force even as its share of gross domestic product declines. CPEC is aimed at addressing two of the factors impeding Pakistan's path to industrialization: fixing its chronic electricity shortages and building a quality road and railway system.

Thus, because export revenue is used to pay for imports, a widening trade deficit has in turn made it harder for Pakistan to finance its imports. This imbalance has compelled the government to borrow from the State Bank of Pakistan and to tap into the country's shrinking foreign exchange reserves. The resulting trade deficit — and the austerity measures tied to the IMF bailouts needed to ultimately address it — will dampen further growth. This will likely drive up jobless claims, since the economy needs to grow at a 6.6 percent rate to create enough employment to accommodate the 1.3 million Pakistanis who enter the job market each year.

The Way Forward

All told, Pakistan needs an estimated $31 billion in the current fiscal year, hence its dialogue with the IMF. Pakistan has gone to the Washington, D.C.-based guarantor of global monetary stability 21 times since 1958, completing its latest loan program, $6.6 billion, in 2016 under then-Prime Minister Nawaz Sharif. Khan reportedly is seeking to hash out the details of a loan ahead of next month's IMF-World Bank meetings in Bali, Indonesia. If his administration implements its various cost-cutting proposals — including trimming development expenditures, reducing tax and tariff exemptions, restricting nonessential imports, privatizing money-losing public sector corporations, widening the tax base, and raising tax collection targets — the GDP growth rate probably will fall by as much as 1 percent, since curbing development spending will hit an engine of economic expansion. (Indeed, a key driver of the fiscal budget deficit — which reached 6.6 percent of GDP in fiscal 2017-18 — was spending by provincial governments on development projects as lawmakers' terms ended ahead of July's elections.) Meanwhile, withdrawing tax and duty exemptions means that prices on hundreds of items will go up. This will give grist to the political opposition as it moves to criticize Khan's management of the economy.

Ultimately, the road to resolving Pakistan's fiscal and trade deficits will be a long one. Khan will be forced to make unpopular decisions to stabilize the country's finances in the short term so he can be better positioned to address its structural problems. He will seek to advance the country's industrialization in support of a more competitive export base, without which growth of productivity, income, employment and the overall economy will lag. Khan's great challenge will be to strike a careful balance between the impassioned populism that ushered him into office and the pragmatic administration of government necessary to bring his vision of "a new Pakistan" closer to reality.

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